Trading Basics: Using the Right Average

Selecting the right moving average depends on the security type and time frame.

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Moving averages are a part of many traders' analysis tools. A question I usually get from students is, "What period moving average is best to use?" While no one moving average is perfect and works all the time, there is a way to identify the best average for the security and time frame that we are trading.

All securities have cycles that affect the price movement. If we can identify the cycle that is dominating our stock, we can identify with a higher probability when tops and bottoms in price will occur and when we should buy or sell our stock. Cycles are measured from trough to trough. The troughs are the low points in price that correspond with the lows in the cycle. While this sounds complicated, with practice it can become easier.

Looking at the weekly chart of the Nifty (NSE:NIFTY), we can see that the stock index seems to make bottoms at a fairly regular interval.

When we use moving averages, we acknowledge that it is an average of price and that price will move away from that average and revert back during a trend. The average should be much like the black line dissecting the cycle I drew in figure 1 of this article. We want an average that is half the length of the cycle so that it will show our peaks and troughs as movements from and to the average itself.

In an uptrend, we should see prices move away from the average only to snap back to them when the trough of the cycle occurs. If we are changing to a downtrend, then the average would be violated and the price would bounce off of it to the downside before returning during peaks in the cycle. If the average is being violated in both directions, then we do not have a strong trend in that timeframe.

By using the right average for the timeframe you are trading, you can increase your odds for success. Just be careful to check the cycle from time to time as cycles can change with market conditions. We need to adapt with the markets for maximum success. We can use this cycle identification on any security and on any timeframe. Until next time, trade safe and trade well!